Darling, how could you?

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Chancellor Alistair Darling's proposal to introduce a new flat rate capital gains tax sent shock waves through broking community leading to some considerable debate about the pros and cons of selling up before the prospective April decline. Jamie Dunkley reports

Last October, the Chancellor of the Exchequer shook the business world in his pre-budget report by announcing plans to introduce a new flat rate of capital gains tax at 18%. Since then, Alistair Darling's controversial decision has been hotly debated throughout the insurance market.

Under the proposed changes, taper relief on capital gains tax would be scrapped. Previous rules had allowed investors to pay only 10% if they had held an asset for more than two years - a burden which will effectively rise by 80% in April if the plans are given the green light. The proposals would also have a significant effect on employee share ownership, which currently allows basic rate tax payers who have held shares in their employer for at least two years to pay 5% tax. They would now be forced to pay an additional 13% on any gain above £9200 from April this year.

Uncertainty and confusion then followed in December when the Chancellor revealed he was still weighing up his options and he has been in consultation with various parties on the government's plans ever since. Mr Darling conceded he would not publish his revised plans until the New Year - an announcement the business world is still waiting for. A partial u-turn in terms of an exemption for business people selling up to retire also looks likely.

As Post went to press Her Majesty's Revenue and Customs said Mr Darling is expected to make an announcement over the coming weeks.

According to a spokeswoman: "The Chancellor is currently considering a wide range of proposals from organisations with whom he has been consulting on the detail of CGT reform and intends to have further discussion with these groups before finalising his proposals."

Whatever the eventual decision, one of the hottest debates in the insurance industry surrounds the relative merits of brokers selling their businesses before the April deadline. Immediately after the pre-budget bombshell, Tony Cornell, proprietor of Reading-based Cornell Consulting, warned brokers to "beware" of rushing a sale to meet the deadline.

"Smart buyers will realise that sellers are up against a deadline and reduce their price accordingly," he said (Post, 18 October 2007, p16). "There may be a glut of brokers on the market, leading to further price falls. It will not take much for a broker to be worse off, even after the higher tax rate.

"It may well be better to wait until after April to sell. The rules might be changed by then or tax alleviating schemes devised and, if not, there is likely to be a shortage of brokers to buy and prices will rise."

Broker consolidators reacted in a similarly speedy fashion. Swinton is a prime example, announcing a £100m war chest for broker acquisitions in November, anticipating an increase in activity before the April deadline. And Oval has also publicly commented that the tax changes would work in its favour.

The proposals

So what exactly do the proposals contain? Chris Riley, tax manager at accountancy firm Littlejohn Frazer, explains that the changes would only refer to disposals of interests in a business by individuals.

"This could be an individual disposing of their interest in a partnership or a business undertaken in their own name, or of shares held in an unlisted limited company that trades as a broker. Where a company owns the shares in a broking firm, the CGT rules applying to the corporate shareholder remain unchanged.

"Changes to CGT mean that taper relief will be abolished for all disposals of privately owned companies and trading assets, such as properties used in a trading business, with effect from 6 April 2008. This alone will represent a potential increase in the rate of tax of up to 80% - the difference between the previous effective 10% rate and the new 18% rate."

In addition, indexation allowance would be scrapped with the loss of the flexibility of the 'kink test' increasing the differential further (see box, p21).

'Earn-out' agreements pose further problems for brokers looking to dispose of their businesses before the deadline. These refer to additional payments in a merger or acquisition that are not part of the original acquisition cost and are based on the acquired company's future earnings relative to a level determined by the merger agreement. Broking firms are typically sold using earn-out agreements, and payments under such arrangements are likely to be made past the implementation date for the new CGT rate, meaning brokers would still be liable for the new 18% rate.

John Connelly, a partner in Weightmans' corporate team, believes these tax proposals could have negative implications for the government. "When taper relief was first introduced, the government reckoned it was getting more money because people thought 10% was fair and did not employ expensive advisers to devise schemes to circumvent their CGT liability. An increase on this scale is likely to reverse that trend." He continues: "I am struggling to understand the justification other than to penalise those who have worked hardest - often over many years - to grow the economy. The parlous state of the public finances is hardly their fault. However, it will be interesting to see if CGT receipts into the Treasury coffers actually increase in the short to medium-term."

The insurance market

The proposal to scrap taper relief has been slammed by the Federation of Small Businesses, which claims it is the "latest hammer blow to small businesses already feeling betrayed by a 16% increase in corporation tax announced in the 2007 budget".

"Entrepreneurs who have spent years building up their business and planned to sell it to pay for their retirement will see their tax bills rocket by 80%," says chief spokesman Stephen Alambritis. "The situation has thrown the whole marketplace for selling businesses into total confusion, with business owners wondering whether to sell before the April 2008 deadline. The buyers of small businesses are also likely to reduce their offers because they may catch on to the fact that entrepreneurs are desperate to sell."

Mr Alambritis also argues: "The CGT proposals will be a disincentive for investors to back new business ideas and completely contradict the government's promise to promote entrepreneurship in the UK."

He stresses that the Chancellor's decision to postpone his CGT announcement has left millions of businesses in limbo.

Many commentators agree that brokers looking to sell will find it difficult to exit their businesses before the start of the next financial year. Mr Connolly believes this plays into the hands of buyers in the market.

"If you're not locked into a sales process now - and by that I mean exclusivity with an identified purchaser who is incurring professional costs - you're going to find it difficult to exit your business before the start of the next financial year," he says.

"Therefore, any deal you do is likely to fall within the ambit of the new CGT regime. Any half-sophisticated purchaser will be well aware that the vendor has a vested interest in selling before the end of the current tax year. The tax benefit for the vendor is likely to be taken into account in the price negotiations, with the buyer looking to secure a reduced price for meeting the vendor's timetable."

Even if brokers do manage to sell before the April deadline, many will still be caught by deferred payments, which can often be stipulated in hurried agreements. It is unclear whether these, when eventually paid, will be subject to the higher rate. But the proposals have certainly acted to whet the appetite of buyers in the market.

Just last month, Venture Preference completed the acquisition of Manchester-based broker Chambers and Newman and said it expected to complete further deals by April.

Stuart Reid, VP joint chief executive, agrees that brokers face a challenge: "If brokers are looking to sell before the proposed CGT changes come into effect, it's getting very late if they wish to take advantage."

Looking ahead, he predicts: "At the medium-to-top-end there isn't a lot of activity left to happen and in 2008 we may see some of the consolidators being bought. The credit squeeze may have its impact and those brokers who survive through consolidation may find it difficult to find the money to fund their acquisitions."

David Coupe, a partner at law firm Clyde and Co, agrees these tax proposals have prompted an upturn in activity: "We are seeing much more interest in the owners of brokers wishing to sell their businesses at the moment, although generally there still remain more buyers than sellers in the market."

Swinton is certainly one acquisitive broker looking to take advantage of the changes, setting aside its £100m war chest to help fast-track purchases and help brokers benefit from the status quo.

During 2007, the broker acquired more than £50m gross premium income and claimed it was a "daunting time" for brokers looking to sell in the next year - trying to second guess the likely movement of the tax rules.

"The new CGT rules will put pressure on brokers considering their future but I believe that the period from now until the end of the tax year is an exceptionally favourable time for brokers to sell their businesses, prices are high and tax rates are low," Hazel Walker, head of Swinton's acquisition team, told Post in November (22 November 2007, p2). "Brokers have spent years building their business and now want to exit taking the fruits of their hard work with them rather than handing over a sizeable chunk of their proceeds to the tax man."

However, Mike Williams, managing director of UKGI, disagrees: "I see no scramble by brokers desperate to sell their businesses ahead of the change in the flat rate of CGT. Of course, it is bound to increase the pressure on those brokers currently considering a potential sale, but I very much doubt there is a queue of hundreds of brokers believing they will have to find a buyer during the next few weeks to avoid paying more tax."

Double impact

He continues: "As for the impact that the proposed changes will have on brokers looking to sell, remember that multiples have been high for brokers' businesses for some time, so they are in a good position to ask for a slightly higher multiple should tax changes occur. While they may be able to play a little more hard ball, I see no real change in the appetite for brokers to sell. There might be one or two big deals remaining to be concluded, but prices for broking businesses will not change significantly in the immediate future."

Aside from the changes in CGT, brokers will have other things on their mind according to Mr Reid, who says a hardening market could pose problems.

"It will no doubt take longer than we thought for the market to harden but, when it does, watch out for pressure on broker commission. The biggest amount of acquisition activity will be in the smaller broking arena though, with firms operating at below £2m to £3m in premium, with heightened activity in networks."

Phillip Hodson, chief executive officer of Oval, agrees, and claims broker prices will remain high, as insurers and consolidators fight to improve their distribution networks.

"Market rates and the state of UK economy will have a marked effect on broker firms in 2008. Some people have argued that prices are too high and possibly they are, but I think they will probably increase in the short-term because of the drive for more control of distribution."

With an announcement on CGT due at any moment, brokers have much food for thought as acquisitive insurers and consolidators circle round. The run-up to April is certainly going to be an interesting time in the insurance market.

INDEXATION ALLOWANCE

Under the government's current tax proposals, indexation allowance would be scrapped with the loss of the flexibility of the 'kink test' increasing the differential further. This allowance has been available since March 1982 and uplifts the cost of the asset disposed of in the CGT calculation by the Retail Prices Index over the period to April 1998, when it was frozen for individuals.

As the allowance was frozen in April 1998, there will be no effect from its abolition for individuals who acquired or set up their business after this date. Under the current rules, the maximum indexation allowance that could be claimed by an individual is a factor of 1.047 of base cost, assuming the relevant asset was acquired in March 1982. For example, an asset with a base cost of £100,000 would give rise to £104,700 indexation allowance - meaning a total deduction in the CGT in respect of acquisition costs of £204,700.

"The abolition of the kink test is likely to affect fewer businesses as it applies to assets acquired before March 1982," explains Chris Riley, tax manager at Littlejohn Frazer. "When calculating the gain arising on disposal, vendors of assets held before that date can elect whether to base the gain calculation on the original cost, or the value as at March 1982. From 6 April, the gain must be calculated on the basis of market value as at March 1982. This provides complications in calculating such an historic figure - which may lead to increased challenges from HMRC - and may also increase the tax charge for business owners where, for whatever reason, their investment was standing at a loss in March 1982. This is because the gain will be calculated on the lower March 1982 valuation, rather than original cost."

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